BY KENT KRAMER, CFP®, AIF®, Chief Investment Officer, Foster Group
If you were asked to describe what you liked about your favorite food, where would you start? Most of us would not begin with how the specific carbohydrates, lipids, and proteins combine to create a chemical reaction on our taste buds and olfactory nerves. We’d use simpler language to describe our tastes and preferences. In describing what I like about my wife’s carrot cake, I’d mention the creamy, moderate sweetness of the cream cheese frosting and the absence of nuts in the moist spiced cake.
If you were asked to describe what you would like in your investment portfolio, what would you emphasize? Like the food example, you likely would not start by describing the historical and expected correlation and covariance statistics surrounding stocks, bonds, real estate, and other assets. Instead, you might describe your tastes and preferences this way: “I’d be willing to have my portfolio go down by 10% in a single year if I could have some confidence that it would grow by an average of 6% over the next twenty years.”
Good recipes today are a combination of art and science. Leading culinary schools around the world teach chefs about the chemical reactions of ingredients that can be used in cooking. The science behind good food and recipes is quite complex. Thankfully, the enjoyment of the food does not require an academic’s understanding of the science.
Good investment portfolios are also a combination of art and science. One area of portfolio science that is particularly important is understanding sources of expected return and risk and how predictably these sources may interact under various conditions and in specific time frames.
In the late 1950’s, an academic, named Harry Markowitz, analyzed the performance of simulated portfolios composed of two assets, US government bonds (lower risk, lower return) and US stocks (higher risk, higher returns). The surprising result was that, over the time frame researched, a portfolio of 20%-30% in bonds and 70%-80% in stocks had experienced both more return (expected) and less volatility (unexpected) than a portfolio of 100% bonds. It turns out that a variety of investment assets could be combined in this way with positive results. Portfolios consisting of historically optimal combinations of risk and return could be graphed on a line dubbed “The Efficient Frontier.” Markowitz’s Modern Portfolio Theory was like discovering a free lunch, more expected return with less risk.
However, unlike the chemistry of food science, the behavior of investment assets does not reliably repeat, year after year or even decade after decade. While Markowitz’s math combining the historical data for return, risk, and the correlations and co-variances of these time series is rock solid (enough to win him a Nobel prize in 1990), there turns out to be significant unpredictability regarding each asset’s performance in differing time periods.
In a test kitchen, the food scientist combines specific carbohydrates, lipids, and proteins and finds consistently repeatable results, day after day. The portfolio scientist, while also using careful measurements of differing ingredients (e.g. stocks, bonds, cash), finds that the results of these combinations is unpredictable, especially over shorter time periods. What provided a positive contribution to portfolio return in one year may become a detractor in the next. US stocks declined 37% in 2008 and then gained 26.5% in 2009. Over longer time periods, the probability of achieving the historical average performance for US stocks (7.2% above inflation) goes up, but the level of certainty never reaches 100%. The good news is that by thoughtfully combining many assets in a diversified portfolio, the odds of meeting an investor’s longer-term tastes and preferences regarding risk and return can be increased.
Diners at fine restaurants expect a good meal on any evening. Food science and a master chef can produce great results night after night, meeting a diner’s tastes and preferences. An investor, even using Nobel Prize-winning science, understands their portfolio will not meet their tastes and preferences day after day. However, if they can describe their tastes and preferences in terms of risk, return, and, most importantly, time horizon, portfolio science can provide recipes with a good chance of pleasing their financial palate.
All investment strategies have the potential for profit or loss. Asset allocation and diversification do not ensure or guarantee better performance and cannot eliminate the risk of investment losses. There are no assurances that an investor’s portfolio will match or outperform any particular benchmark.
PLEASE NOTE LIMITATIONS: Please see Important Disclosure Information and the limitations of any ranking/recognitions, at www.fostergrp.com/info-disclosure. A copy of our current written disclosure statement as set forth on Part 2A of Form ADV is available at www.adviserinfo.sec.gov. ©2019 Foster Group, Inc. All Rights Reserved.
| Kent Kramer